19. Embedded Values

Question 1

What were the problems with the APM? (4)

Answer 1

1. No guidance on the treatment of embedded options.
2. No robust framework to reflect risks.
3. Inconsistent approaches
4. Limited disclosure of methods and assumptions.

Question 2

List the EEV principles. (12)

Answer 2

1. Definition of the EEV
2. Business covered
3. Definitions
4. Free surplus
5. Required capital
6. PVIF
7. Financial options and guarantees
8. New business
9. Assumptions
10. Economic assumptions
11. Participating business
12. Disclosure

Question 3

Which three areas did the EEV guidance require companies to increase the level of disclosure? (3)

Answer 3

1. Sensitivities
2. Analysis of movement in EEV
3. The basis of any external review of methodology, assumptions and results.

Question 4

State EEV principles 1 and 2. (2)

Answer 4

1. EV is a measure of the consolidated value of shareholders interest in the covered business.
2. The business covered by the EV methodology should be clearly identified and disclosed.

Question 5

State EEV principle 3. (5)

Answer 5

EV is the present value of the shareholders’ interest in the distributable earnings on the assets backing the covered business after sufficient allowance for the aggregate risks in the covered business.

The EV consists of the following components:

i) Free surplus allocated to the covered business.
ii) Required capital, less cost of holding required capital.
iii) PV of the future shareholder cashflows from the inforce covered business (PVIF).

Question 6

What do EEV principles 4, 5 and 6 have to say about the three constituent parts of the EV? (6)

Answer 6

4. The free surplus is the market value of any capital or surplus that is allocated to, but not required to support the in-force covered business at the valuation date.
5. Required capital includes any assets allocated to the covered business over and above that required to back the liabilities, whose distribution to shareholders is restricted. The EV should allow for the cost holding the required capital.
6. The value of future cashflows from in-force covered business is the present value of future shareholder cashflows projected to emerge from the assets backing the liabilities of the in-force covered business.

Question 7

What does EEV principle 7 have to say about options and guarantees? (2)

Answer 7

Allowance must be made in the EV for the impact on future shareholder cashflows of all financial options and guarantees within the covered business.

This allowance must include the time value of financial options and guarantees valued using a stochastic approach.

Question 8

What do EEV principles 9 and 10 have to say about assumptions? (5)

Answer 8

1. The assumptions for projecting the future cashflows must take account of all available information.
2. Changes to assumptions should be made when sufficient evidence exists that the existing assumptions are out of date.
3. The assumptions should be actively reviewed (at least annually).
4. Economic assumptions must be internally consistent and consistent with observable, reliable market data.
5. No smoothing of any economic assumptions is permitted.

Question 9

What does EEV principle 8 have to say about new business? (3)

Answer 9

New business is defined as that arising from from the sale of new contracts during the reporting period.

The value of NB includes expected future renewals and contractual alterations to those new contracts.

The EV should only reflect inforce business, not future new business.

Question 10

What does EEV principle 11 have to say about participating business? (5)

Answer 10

For participating business, assumptions must be made about future bonus declarations and the split between policyholder and shareholder entitlement.

These assumptions should be consistent with:

1. Established company practice
2. Local market practice
3. The projection assumptions

Question 11

State EEV principle 12. (1)

Answer 11

EV results should be disclosed at consolidated group level using a business classification consistent with the primary statements.

Question 12

What three issues are not covered by the EEV principles and are left up to individual companies to decide upon? (3)

Answer 12

1. How to set the appropriate risk discount rate
2. How to calculate the cost of options and guarantees
3. What adjustment to make for the cost of capital

Question 13

Summarise the movement from EEV principles to MCEV principles. (6)

Answer 13

1. Although the EEV principles left the options open, over time companies moved to using a market consistent approach.
2. The CFO Forum released MCEV principles in 2008 moved the approach towards consistency and transparency and formalising the approach that many companies were already taking.
3. An amended version of the MCEV principles were released in 2009, addressing the need for a liquidity premium in the discount rate.
4. It was the intention that the MCEV principles be mandatory for CFO Forum members, replacing the EEV principles.
5. However, it remained voluntary in light of developments of Solvency 2 and IFRS17.

Question 14

Under Solvency 2, the BEL has no prudential margins to be released as PVIF. State four reasons why a PVIF component of the EV may still be needed. (4)

Answer 14

1. Profits that are expected beyond the Solvency 2 contract boundaries.
2. Any difference between the best estimate investment returns used in the EV projection basis and the risk free yield curves used in the BEL (including any matching or volatility adjustment).
3. Future shareholder transfers in respect of with profits business to the extent that these are not already allowed for in “own funds”.
4. The release of the risk margin, after allowing for the cost of holding it.

Question 15

Within an analysis of change in EV under Solvency 2, what are the three component parts that can be separated? (3)

Answer 15

1. Change in net assets (or free surplus)
2. Change in PVIF (if a PVIF is included in the EV)
3. Change in Risk Margin and SCR (after allowing for frictional “lock-in” costs).

Question 16

Describe customer value measurement and management. (5)

Answer 16

1. Customer value measurement and management relates to the value that is placed on an existing or new customer throughout their lifetime.
2. Customer value is often monitored through persistency rates, including profits from the expectation of multiple policy purchases over a customer’s lifetime.
3. Analysis of the impact on customer value of business decisions can help a company maximise its profits.
4. Simulation approaches can be used, although modelling is usually complex and subjective.
5. Life assurance companies with large legacy portfolios or closed funds may perform customer value analysis in order to maximise the profit that can be extracted, subject to TCF.